Executive Compensation and How It Works

In my last article about stock options, I mentioned how executives’ pay is oftentimes comprised mostly of stock options, particularly in large, public companies.  A 2000 Harvard Business Review study put the figure at 98% of compensation being option-based, which is quite staggering, though more recent studies (2015) have pegged the figure at about 25%.  You, the reader, are probably not a C-suite executive, but you should care very strongly about how the compensation structure works within your investments.  Stock options are used only because they are believed to more closely align value creation and management interests.  Shareholders, of which both you and the C-suite executives are, benefit directly from value creation through stock price.  So, aligning management interests most closely with investors means their compensation structure must align value creation with pay.

First, let’s take a brief foray into moneyness.  This is a term used to describe the value of a stock option.  “In-the-money” means exercising the option would yield a positive gross profit, i.e. a call option on a $100 share with a strike/exercise price of $90 is in the money.  “Out-of-the-money” is the opposite, wherein the option is underwater.  A call option on the same $100 share, but with a strike price of $110, is generally considered “out of the money”.  “At-the-money” is an option that would break even, i.e. an option on a $100 share with a $100 exercise price, and this is what managers are usually given.  Knowing this, it’s simple to see some room for abuse or manipulation, namely backdating options.  This is essentially the process of changing the date that the option was granted on, so as to lower the “at-the-money” price.  The SEC started investigating when researchers and investors began to turn in evidence that many companies just so happened to grant options on the day when their stock price was lowest in a given time period.  This increased executive compensation unfairly (and illegally); so now, the SEC requires the dates of option grants to be disclosed to avoid manipulation.

Now, the basic premise is that the at-the-money option will only have value to management if the stock price of the company rises.  Shareholders believe management will work hardest to grow stock price, since their compensation depends on this growth, but it also leads to its own set of problems.  Management may focus exclusively on short-term goals, like hitting quarterly earnings targets, inorganically growing the company (mergers and acquisitions), and failing to invest in the long-term growth strategy.  A 2014 study in the Chicago Booth Review even found that a 10% increase in the value of new options led to 2-6% greater volatility in stock price, caused primarily by increasing use of debt.  This doesn’t act in the best interest of the shareholders who are invested long-term in the company, and may want to hold beyond when the executive’s stock options will be exercised.

However, entrenched management, or those with many unexercised options and an eye for retirement, tend to leave value creation “on the table”, so to speak.  These long-tenured managers steward the company very conservatively, forgoing riskier projects in order to protect what gains they themselves have made.  This also harms shareholders, as they want the maximum possible sustainable growth for their investment.  What’s more, value creation is the reason they directed the board to give stock option compensation in the first place!

Lastly, of course, a rising tide lifts all ships, so if the entire stock market is improving, there are many companies (and executives) that will make a mint, somewhat regardless of how much value they create.  This helps shareholders, but it does little to differentiate management from any other management, which is something a discerning investor wants to do.  So, if simply giving executives stock options doesn’t necessarily align their interests with shareholders, what will?

There are two key restrictions that shareholders should want management’s stock options to have, and these aren’t necessarily bad for the executives either. The first is vesting, which addresses the short-term incentives.  This is the process by which an executive receives a large number of stock options, but can only exercise a portion of them over time.  An HBR study uses the example of “25% per year over four years” or some such similar plan.  The second is to use a fixed number plan, rather than a fixed value or megagrant plan.  This means that the executive will receive a “fixed number” of options at predetermined intervals, rather than, for example, 5 or 10 years worth of options all at once (megagrant).  So, the more value they create over the timeframe of the plan, the more money they can make.  This is a significant advantage over fixed value plans, which deliver a specific option value to the executive, decreasing the quantity of options as the stock price improves.  It’s also beneficial in the event of a market crash, or any other factor that significantly lowers the company’s stock price.  If this occurs, a fixed number plan won’t be entirely out-of-the-money, like a megagrant plan, because the executive will receive another round of at-the-money options at the now much lower stock price (assuming they’re still with the company).

As a small investor, your ability to influence CEO compensation structures will be limited, to say the least.  However, it is important to understand how their compensation works and what incentives they have in stewarding your investment.  That’s not to say that you shouldn’t invest in companies because of their megagrant option structures, but you can factor that into your decision.  Additionally, you’d like to see an evolution as the company matures, i.e. a start-up with a megagrant structure grows to become an expanding/mature public company with a fixed number plan.  This shows the company is thinking critically about long-term growth and management incentives.

Sources

Cox, Christopher. Testimony Concerning Options Backdating. SEC.gov, www.sec.gov/news/testimony/2006/ts090606cc.htm.

Fink, Ronald. Should You Give Your CEO Stock Options? Chicago Booth Review, 20 June 2014, review.chicagobooth.edu/magazine/summer-2014/should-you-give-your-ceo-stock-options.

Gilroy, William G. Throwing Caution to the Wind: CEO Stock Option Pay May Increase Product Safety Problems. Notre Dame News, 31 Aug. 2015, news.nd.edu/news/throwing-caution-to-the-wind-ceo-stock-option-pay-may-increase-product-safety-problems/.

Hall, Brian J. What You Need to Know About Stock Options. Harvard Business Review, Harvard Business School, 1 Aug. 2014, hbr.org/2000/03/what-you-need-to-know-about-stock-options.

Incentive Plans: Stock Options. Compensation, HR Guide, hr-guide.com/data/G445.htm.

SEC. Spotlight on Stock Options Backdating. SEC.gov, www.sec.gov/spotlight/optionsbackdating.htm.

Staff, Investopedia. Moneyness. Investopedia, Investopedia, 16 Mar. 2018, www.investopedia.com/terms/m/moneyness.asp.